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Wondering what’s weighing your credit score down? Your current outstanding debt may be affecting your credit score, including your FICO score. Your debt-to-income, or DTI, ratio is a percentage that compares your monthly debt expenses to your monthly gross income.
As a borrower you should always keep your debt at a comfortable level. But how much debt is too much debt? Luckily, there is a way to estimate if you have too much debt without waiting until you realize you can’t afford your monthly payments.
What is My Debt-to-Income (DTI) Ratio?
There are two different major forms of DTI ratios.
Front-end ratio refers to the first type of debt-to-income ratio; this ratio pertains to the percentage of income spent on housing costs or rental costs. These costs typically involve mortgage payments, associated interest, and property taxes. In a nutshell, the front-end ratio denotes the amount of income spent on typical property costs.
On the contrary, the other type of debt-to-income ratio is the back-end ratio which involves all other debt payments aside from housing costs. It is the percentage of income that goes towards debt payments for credit cards, student loans, car loans, investment loans, child support payments, legal payments, or alimony payments.
In order to calculate the DTI ratio, or each respective end ratio mentioned above, you must sum up monthly payments made towards either housing costs (front-end ratio) and other debt payments (back-end ratio) and divide by the total monthly income. Multiply each number by 100 to find each respective percentage of income spent towards these debt payments. By taking the sum of front-end ratio and back-end ratio, the total DTI ratio is found. Total DTI ratio can be easily found by simply combining front-end and back-end costs from the start which makes for one less division step; regardless, the same number will be calculated.
Here is a simplified example ignoring the difference between front-end and back-end ratios. For example, if you pay $700 on credit cards, $300 on car loans and $2,000 a month in rent, your total monthly debt commitment is $3,000. If you make $60,000 a year, your monthly gross income is $60,000 divided by 12 months for a total of $5,000 a month. Your debt-to-income ratio is $3,000 divided by $5,000, which works out to 0.6 or 60%
Why is My Debt-to-Income Ratio Important?
DTI is used by most lenders and banks to understand the type of debt situation you are in and your ability to repay future debt. It is important for these companies to understand how much debt their customers can take on before those customers start having financial difficulties.
Financial services companies typically prefer their borrowers to have 36% DTI or lower. In simple terms, the less debt and more monthly income creates a better debt-to-income ratio. A better debt-to-income ratio is a lower percentage value, so a lower percentage value for DTI increases the chances of receiving a loan. If you have a DTI closer to 100%, there is a lower chance that you will make it through the underwriting process and be approved for the loan.
Tips to Lower Debt-to-Income Ratio:
If your DTI is higher than 36%, some lenders may be less likely to approve an application for credit. There are multiple ways to lower your debt-to-income ratio; by following certain key pointers, anyone has the ability to lower their debt-to-income ratio. Let’s work together and lower your DTI using these tips:
- Postpone Large Purchases Until You Have More Savings. If you’re planning to make a large purchase via a loan or by using a credit card, hold off for now. If you make a larger down payment your total credit balance will be lower, helping to keep your debt-to-income ratio low. In other words, you are saving future earnings from being devoted to previous debt accrual.
- Increase the Amount You Pay on Your Debts Each Month. Extra payments can help lower your overall debt more quickly. By reducing the amount of debt over time, you are gradually decreasing your debt-to-income ratio. There are two possible ways to lower your DTI: decrease debt (by paying off more debt) or increasing income (by making a promotion or more typically having less debt the next month!).
- Stop With the Debt. Consider reducing the amount you charge on your credit cards, use your debit card instead. Do not think of the credit card as a typical way to spend. It is ok to buy essentials with a credit card if it is absolutely needed immediately, but realistically speaking, this purchase is made by the banks. You owe them that money later which counts as debt. By spending money from a debit account, you circumvent the debt process by spending money you own at the current moment.
- Recalculate Your Debt-to-Income Ratio Monthly to see if You are Making Progress. Stay motivated and set goals to strive towards. Reducing debt requires hard work and sacrifice. Do not be afraid to reward yourself every once in a while, but do not lose sight of your monthly goals!
The better your debt-to-income ratio, the lower rates you can obtain on most financial products including personal loans, student loans, mortgages, and more. Overall, by improving your debt-to-income ratio you will improve your financial health.